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Bank of America Merrill Lynch cracks down on risky securities with ban on penny stocks

Key Points
  • The bank's Merrill Lynch division banned purchases of the risky securities in late July, and added restrictions to sales in September, according to sources.
  • Starting Sunday, stocks priced under $5 per share from companies with a market capitalization under $300 million will be subject to a regulatory review, according to a copy of rules obtained by CNBC.
  • Bank of America appears to be the first major wirehouse to restrict the purchase of penny stocks. Rivals Morgan Stanley and UBS still allow the trades in some instances.
  • Penny stocks can easily be manipulated for fraudulent purposes, according to talking points distributed to Merrill Lynch brokers.
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Bank of America bans penny stocks

Penny stocks are no longer welcome at Bank of America's Merrill Lynch brokerage.

The company recently told clients it was changing its trading policy regarding penny stocks.

The bank's Merrill Lynch division banned purchases of the risky securities in late July, according to the people, who declined to be identified speaking about the move. About six weeks later, the bank abruptly said it was restricting clients' sales of penny stocks, then amended that policy to give financial advisers more time to exit positions, the people said.

Penny stocks, which the Securities and Exchange Commission defines as a small company trading for less than $5 a share and on an over-the-counter market, occupy a disreputable corner of financial markets. Since the shares are thinly traded away from major exchanges and face few disclosure requirements, they have for decades been a tool for fraudulent schemes. One common approach is the pump-and-dump where criminals hype a stock before exiting positions. That was the method Jordan Belfort, the so-called Wolf of Wall Street, used to enrich himself before getting caught.

Regulators have increasingly made their views of penny stocks known. The SEC's Division of Economic and Risk Analysis published a white paper in 2016 highlighting the risks of investing in over-the-counter markets. The majority of investors lose money in the trades, and losses worsened for stocks that were the subject of promotional campaigns and those that had weaker disclosures, the SEC said.

Bank of America is first

Bank of America appears to be the first major wirehouse to institute an outright ban on the purchase of penny stocks. While other firms have review processes for these riskier trades, it's still possible to buy penny stocks at Morgan Stanley and UBS, according to people with knowledge of those firms' policies.

The move is the latest example of Bank of America pulling back on potentially risky activities. CEO Brian Moynihan has spent much of his tenure spending billions of dollars securing settlements with regulators. He often repeats his "responsible growth" mantra, and signs of the impact of that strategy abound.

In February, the bank halted clients from using credit cards to purchase bitcoin and other cryptocurrencies. The firm's investment banking head, Christian Meissner, reportedly left earlier this month after clashing with Moynihan over the division's risk appetite.

Still, the policy shift around penny stocks at Bank of America has sown confusion among some of the firm's 17,442 financial advisers.

"We were told to get rid of them by a certain date," said one Merrill Lynch broker. "I called compliance today to say my client doesn't want to do that. Now they're telling me he doesn't have to sell, but it could be hard to get rid of it down the road."

After initially banning the sale of most penny stocks, the firm put the policy under review, allowing most of them to be sold for at least the time being, according to one of the sources. Only the riskiest penny stocks that already may be the target of fraudulent schemes — labeled with a skull-and-crossbones icon by the trading firm OTC Markets Group — can no longer be sold. Eventually, all penny stocks could fall under the restriction, the person said.

Clients who can no longer sell penny stocks through Merrill Lynch have to transfer them to another brokerage to liquidate the positions. Some clients have had difficulty selling their holdings at rival brokerages, which are beginning to place restrictions on the asset class, according to one of the people.

Under $5

The bank sent clients another letter earlier this month. Starting Sunday, stocks priced under $5 per share from companies with a market capitalization under $300 million will be subject to a regulatory review, according to a copy obtained by CNBC. Clients who want to sell "will experience a delay in execution" because of the review, the firm said.

The bank took steps regarding low-priced stocks "to ensure we are complying with Securities and Exchange Commission regulations and protecting the interests of our clients," said Jerry Dubrowski, a spokesman for the bank. "As a result, certain transactions may be subject to restrictions, trading prohibitions or other limitations."

Penny stocks are illiquid and can easily be manipulated for fraudulent purposes, according to talking points distributed to Merrill Lynch brokers. The asset class is rife with companies with shaky businesses. Other times, they are legitimate companies that have been delisted from major exchanges as they near bankruptcy.

Still, the high volatility of the asset class — in which shares worth a few pennies can rocket in value — invariably lures retail investors.

That happened in July 2014 with Cynk Technology, when a company with no discernible assets, revenue and a single employee surged from 6 cents a share to $21.95, or a market cap of more than $6 billion. The next year, a Canadian citizen named Philip Kueber was accused by U.S. authorities of engaging in a $300 million stock manipulation fraud.

According to the SEC's 2016 white paper, retired, low income and less-educated investors fared the worst with penny stocks. The agency analyzed 1.8 million trades by 200,000 investors, finding that the typical return is "severely negative."

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