What are OTC securities?

Over-the-counter (OTC) securities are securities that are not listed on a major exchange in the United States and are instead traded via a broker-dealer network, usually because many are smaller companies and do not meet the requirements to be listed on a formal exchange. There may be additional steps and fees when trading OTC securities because trades must be made through market makers who carry an inventory of securities to facilitate trading. 

There are approximately 10,000 OTC securities that make up a wide array of different companies, including large-cap American Depositary Receipts (ADRs), foreign ordinaries, and small and micro-cap growth companies. While some OTC securities report to the Securities and Exchange Commission (SEC), others may follow a different reporting standard or may not file reports to any regulatory body. 

Understanding the risks of OTCs

OTC securities present a number of additional risks, compared to securities that trade on a national exchange. 

Lack of publicly available information

The biggest difference between an OTC stock and a listed stock is the amount of publicly available information about the company. Information about OTC companies can be difficult to find, making them more vulnerable to investment fraud schemes and making it less likely that quoted prices in the market will be based on full and complete information about the company.

No minimum listing standard

Companies quoted on OTC Markets generally do not have to meet any minimum standards, although companies quoted in OTC Market Group’s OTCQX and OTCQB marketplaces are subject to initial and ongoing requirements.

Business and financial risk

While all investments involve risk, microcap stocks (market capitalization of $50 to $300 million) are among the most risky. Many microcap companies are new and have no proven track record. Microcap stocks often have low trade volume. Any size of trade can have a material impact on the price.

Types of OTC tiers

OTC Markets Group, a third party, has created three tiers based on the quality and quantity of publicly available information. These tiers are designed to give investors insights into the amount of information that companies make available. Securities can move from one tier into another based on the frequency of financial disclosures. The tiers give no indication of the investment merits of the company and should not be construed as a recommendation. 

OTCQX

This is considered the highest tier of OTC Markets' securities based on the amount of available information. In order to be eligible for the OTCQX tier, the firms must be current on all regulatory disclosures, maintain audited financials, and cannot be a penny stock, a shell corporation, or be in bankruptcy. 

OTCQB

This tier is designed for early-stage or growth companies. Companies must have a minimum bid price of $0.01. These companies must be current in their regulatory reporting and have audited annual financials in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Similar to OTCQX, these companies cannot be in bankruptcy.

Pink Market ("Pink Sheets")

This tier is also known as the Open Market. There are no minimum financial standards, and it can include a wide variety of companies, including foreign companies, penny stocks, shell companies, and other firms that choose not to disclose financial information. Within the Pink Market, firms are classified as showing Current Information, Limited Information, or No Information. 

Grey Market

All other securities that are traded over-the-counter are on the Grey Market. Grey Market securities are not quoted by broker-dealers due to a lack of investor interest, lack of financial information, or lack of regulatory compliance. 

Shell Game: Reverse Mergers and Custodial Plays Making Penny Stock Investors Big Bucks

For those with a few hundred or a few thousand looking to potentially double their money or more in a day or a week — the penny stock world is where it’s at. The latest trends bringing these monster payouts have been custodial plays and reverse mergers.

Custodial plays are when a “shell cleaner upper” of sorts comes in and takes over a defunct publicly trading company. A shell, a public company that has a share structure in place, but no real assets or company inside it. These shells, due to having no business in them, most likely will not trade, will not have filings and will not release news – thus falling dormant. Due to the fact the stock has become a “ghost town”, the share price has been beaten up and usually at 52 week lows with a market cap equal to peanuts.

When a custodian comes in and takes control of the shell company, they most likely clean it up with hopes of finding a private company looking to reverse merge into the shell. The excitement, anticipation and speculation of someone putting a new business and assets into the shell draws penny investors into these lottery style plays. OTC investors call these “lottos”, because the risk to reward potential is significant.

The mindset of the investor is that I'm buying shares of a depreciated company cheap, with hopes of a company worth lots of money reverse mergers into it, thus making the valuation of the shares I own, worth a lot more.

How Crypto Startup HUMBL Became the Top Penny Stock of 2021

By Thomas Yeung, CFA, InvestorPlace Markets Analyst Mar 6, 2021, 11:00 am EDT

In early February, a virtually unknown company, Tesoro Enterprises (OTCMKTS:TSNPD), suddenly found   itself as the largest actively traded company on the OTC market. At a $7 billion valuation, the company was briefly worth more than JetBlue Airways (NASDAQ:JBLU) and GoPro (NASDAQ:GPRO) combined. But there was one problem: Neither the company nor its merged entity HUMBL had a full-fledged operating business quite yet.

Instead, the combined entity was merely an early stage startup — a dream and a series of test products put forth by its charismatic CEO and his team. Its multi-unicorn status was merely a product of its OTC share price — a number controlled by penny stock investors, not by the company itself. As the firm rides a second crypto wave, one thing will become apparent: The party is only getting started.

Tesoro’s rise illustrates a broader shift: Retail investors have found their way into the world of earlier-stage investing. The recent surge of SPACs, initial coin offerings and OTC stocks mean that ordinary folks can now buy into companies that were once only available to angel investors and venture capitalists.

The trend won’t reverse anytime soon; big investor paydays will see to that. But as Wall Street and tech CEOs keep chipping. After all, removing the training wheels cuts both ways.

That means runaway stocks like Tesoro/HUMBL will happen more often. And only those who understand their anatomy can consistently profit in this wild new world of early stage investing.

TSNP Stock and HUMBL: A Marriage Made in Crypto-Land

In November, HUMBL, a global payments startup, merged with Tesoro Enterprises in a deal worth about $10 million. Tesoro Enterprises itself was a relatively inactive company trading on over-the-counter pink sheets. Its final official SEC financial filing came in 2007, where the “value added reseller of ceramic floor and wall covering products”  reported on its bankruptcy. After filing another small offering in 2010, the company went silent for over a decade.

HUMBL, meanwhile, was a hot startup in the payments and blockchain space. The young company, founded by CEO Brian Foote, was awarded the “Best North America Startup'' at the 2019 World Blockchain Summit.

Why would a payments startup merge with a tile distributor? Without any apparent synergies, HUMBL’s management likely did the deal so that they could access over-the-counter (OTC) capital markets – the wild west of finance.

OTC Markets: Unimaginable Wealth and a Backwater of Bankruptcy

The Wall Street establishment tends to look down on the OTC market. With minimal reporting requirements and off-exchange dealings, scam companies can often pass off as legitimate ones. It’s also where many de-listed companies go after their shares become worthless.

However, the OTC market is much like visiting Grandma’s house and getting ice cream for breakfast: It offers a do-anything attitude that would make mom (i.e., the SEC) furious. Companies aren’t required to file audited financial statements, making it a cheap place to do business. And OTC markets also allow companies to deal in legal grey areas. The Grayscale Bitcoin Trust (OTCMKTS:GBTC), for instance, trades OTC — making it the largest non-company entity on the exchange.

HUMBL Takes on OTC Markets

During ordinary times, a startup like HUMBL might have ignored OTC markets altogether — raising money from angel investors and venture capital instead. It’s a well-worn path for promising young firms to access deep pockets and technological know-how. But with venture capital increasingly focused on larger, later-stage deals, HUMBL decided to go a riskier route.

The plan worked. After its merger in November 2020, TSNP stock rose from a penny to over 16 cents, a stunning 1,500% return. Much of this was from a smart investor relations campaign — the song and dance that most startups perform for their VC overlords. HUMBL did the same for penny stock investors, and its early announcements created the intended result on its stock price.

But in late January, things started to spiral out of control. In eight days, the company announced launches in international payments, e-commerce and blockchain products. Its shares immediately jumped to $1.91, an almost 20,000% gain from barely two months before.

By the time the company announced the launch of its “BLOCK ETX Products,” its market value of $7 billion had surpassed the two pure-play blockchain companies listed on the Nasdaq Exchange: Marathon Digital Group (NASDAQ:MARA) and Riot Blockchain (NASDAQ:RIOT).

There was one problem: HUMBL was still a startup. Its products were a collection of test cases, or “minimally viable products” (MVPs). VCs might have seen right through, valuing HUMBL in the tens (or hundreds) of millions of dollars. But they certainly wouldn’t have paid $7 billion for the firm. (To reach that valuation, the firm would have needed to look like Uber in late 2013, the year the ride-hailing firm would reportedly earn $210 million on over $1 billion of rides).

OTC investors, however, didn’t seem to care.

HUMBL’s Unexpected Rise

To understand how HUMBL became a $7 billion company, let’s rewind to December 2020, when the company started its three-stage investor-relations push.

Act I, December 2020: e-Commerce. That month, HUMBL launches HUMBL Holiday Deal Days, a destination for “highly curated holiday deals, coupon codes and affiliate discount links in shopping verticals like electronics, health, beauty, home, fashion, fitness, and kids.” Investors might have initially cheered at the news. Like Grandma’s ice-cream breakfast, only a killjoy could turn down “highly curated holiday deals.” But experienced VCs checking the humblpay.com site would have noted the true MVP nature of the product. Rather than deliver on the promise of “highly curated,” the site instead posted links to retailers like World Market and Target as placeholders for future products.

Act II, January 2021: Global Payments. HUMBL launches HUMBL Studios, a “global merchant listings and web payment integrations” service. Again, the “launch” is a great start for an MVP, leaving room for a future payment system. A quick check on Builtwith, a website that checks technology platforms, and a quick call with the firm, confirms that HUMBL runs Stripe as its payment processor.

Act III, February 2021: Cryptocurrency. HUMBL makes its most significant announcement yet: “HUMBL Financial™ Launches BLOCK ETX Products in Over 100 Countries.” The press release sent TSNP/HUMBL stock soaring to its $7 billion market cap. And rightly so — financial firms have long tried to launch Blockchain ETFs for regular investors. The first firm to achieve that globally could become the next billion-dollar commodity ETF.

Sharp readers, however, would have noted that the BLOCK ETX product is still in a beta testing phase. The outcome was “not intended to be investment services or advice but rather, are completely non-custodial.” In other words, BLOCK ETX is a representation of an ETF, not an ETF itself. (For non-crypto investors: It’s the difference between buying a $100,000 sports car versus buying a $50 manual on how to build one).

The Reality Behind OTC Companies

All this might remind cynics of the Fyre Festival fiasco, a luxury music festival in 2017 that ended with thousands getting stranded on an island in the Bahamas. While concert-goers were promised “a luxurious getaway on a private island of Exuma, live music from top artists and partying with famous celebrities,” people mostly ended up with leaking tents and Styrofoam-packed dinners. Many will fondly remember the viral photo of a cheese sandwich meant for the crew.

But VC investors and HUMBL fans would rightly disagree. HUMBL’s press releases look much like a startup pitchbook — filled with entrepreneurial dreams, visions and test cases of where the products might finally fit in. But while VC investors have steeled themselves against overselling, the same can’t be said of penny stock investors who sent TSNP stock to the moon.

Still More Questions

In a post-regulation world, some might find this early stage investing rather exciting. TSNP stock would have made any quick-thinking penny stock investors extraordinarily rich. And virtually all VC-funded startups go through a “fake-it-til-you-make-it” cycle to raise capital and build world-beating products. It’s not clear if that’s what’s going on here. After all,  HUMBL’s BLOCK ETX product, for instance, has incredible real-world applications.

There’s also a hero element: Brian Foote. HUMBL’s CEO has probably become a billionaire thanks to his initial investment in the firm – a feat that takes most successful startup founders years, not two months, to achieve. (That’s, of course, if he bought at least 20% of the company in its penny-stock days).

But OTC investing also has costs: Those who bought at the top of the TSNP ride would have seen their wealth get torpedoed as TSNP stock sank back below $1. And Mr. Foote is under no obligation to build the products his firm has promised to bring. With virtually zero reporting requirements, he could readily sell his shares and walk away from the company without anyone ever knowing. Its acquisitions of unrelated businesses might also worry investors who would rather see HUMBL build out its core crypto products.

What Can We Learn?

Audited financial statements aren’t perfect — plenty of companies stretch reality and even sometimes fake their numbers. But they’re the most objective source of truth that investors have. Since the Sarbanes-Oxley Act passed in 2002, corporate executives now face jail time for filing misleading financial statements.

Early stage investors, however, don’t have that luxury. Instead, they’re faced with companies like HUMBL: A black box that could be the next PayPal or (very often) the next zero. Studies show the average OTC investment drops 60% every year.

So which one is it? HUMBL investors had collectively lost $4 billion since the stock peaked in early February before seeing an equally fast ride back up. But it’s only when the company re-lists on a major exchange and publishes audited statements that investors will finally find out what’s under the hood.

Until then, we can all hang onto the dream that only penny stocks, VC-funded companies and slot machines can provide — that magical ticket that might one day turn out to be a beautiful winner.

Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.

Popular Custodians

At least in the social media land (aka twitter and financial forums), investors that take advantage of these style of plays tend to follow a handful of players in the custodianship world of over the counter shells. These names that circulate are George Sharp, David Lazar, Joe Arcaro, Mr. Glass and Rhonda Kheveaney.

Earlier this year, some custodial plays were on fire also. Here is a well written informative article that goes into great detail explaining the custodial process, what they are, the difference between a legal and a fraudulent takeover, along with what exactly happens after custodianship is granted.

The 2 Waves of Custodial Plays

So, it seems as if there are 2 waves of opportunity when investing in these “custodial plays”. The first wave comes when investors catch wind the shell is up for a legal/court decision on whether or not the custodian is granted control of the company. This can generate a significant amount of interest and share price appreciation because traders know that this shell will eventually be on the block as a reverse merger vehicle for an opportunistic private company looking the enter the public arena. The first wave of investors are made up of quick flippers that will play the anticipation and feed off the custodial traders and lotto players – they are in and out. The rest wait patiently for the reverse merger to happen and create the 2nd wave.

The 2nd wave happens when the new company buys a controlling interest or puts an asset (usually a new corporation) into the public vehicle. Again, investors hope that new company is worth millions and millions as it comes down to basic math after that. The more the company is the worth, the more the shares will be worth and the bigger the potential gains.