The Twilight Zone: OTC Regulatory Regimes and Market Quality

More than 8,000 domestic equity securities were publicly traded in the U.S. OTC market in 2010. Yet, research studying this market is limited. Stocks in this market tend to be small. The OTC market generally offers less investor protection than the traditional exchanges, and fraudulent and abusive practices in this market cause significant economic harm to investors. Thus, this market illustrates the trade-off that securities regulators face between their charter to ensure investor protection and their desire to create a viable market for small growth firms. This trade-off has come into focus with the passage of the JOBS Act in 2012, which intended to lower the regulatory burden on small growth firms to access public capital markets. One of its key provisions provides more generous exemptions from SEC registration. This change raises significant concerns with respect to investor protection. In light of such initiatives, it is important to understand the efficacy of existing regulatory regimes in the OTC market. Our paper, which is forthcoming in the Review of Financial Studies, analyzes the association between these regulatory regimes and market quality. 

During our sample period, the OTC market consisted of three venues: the Bulletin Board, the Pink Sheets (now called the OTC Markets Group) and the Grey Market. Bulletin Board firms have had to file with the SEC since the passage of the Eligibility Rule in 1999. The Pink Sheets and the Grey Market do not require SEC registration. However, until the JOBS Act, any publicly traded firm with more than $10 million in assets and more than 500 record holders was required to file with the SEC. Thus, firms trading in the Pink Sheets or the Grey Market may also be SEC filers and hence provide regular disclosure. For SEC registrants, federal law preempts state regulation and sets the relevant rules. For non-registrants, state securities laws (also called ‘blue sky’ laws) require registration, which in most states amounts to a ‘merit review’ of the issuer. An important way in which firms can comply with state securities laws is to use the so-called ‘manual exemption’. Specifically, issuers in 41 states and the District of Columbia that appear in a national recognized securities manual are exempt from registration. The manual providers (eg, Mergent, Standard & Poor’s) perform a basic review of documents supplied by issuers and publish a brief business description and company financials. In addition to federal and state regulation, there are venue-based regimes. In 2007, the Pink Sheets market operator (now called the OTC Markets Group) introduced several tiers and information labels differentiating firms for which current information, limited information or no information is available. It also created a ‘Caveat Emptor’ label to flag firms with public interest or fraud concerns. 

We first show that the OTC market consists predominantly of micro-cap stocks that exhibit low market liquidity, negative stock returns and high return volatility. A significant number of firms in the OTC markets are ‘fallen angels’, ie, stocks that have delisted from the traditional exchanges. We also show that few OTC firms eventually trade up to the traditional exchanges. At the same time, most OTC stocks survive for long periods of time, even those delisted from the exchanges. Thus, the OTC market is more than an interim home for firms that are on their way out of the public markets. 

A key question is how regulatory regimes with different levels of transparency and investor protection affect investor demand and market quality. We study this question focusing on market liquidity and crash risk as proxies for market quality. Our main tests show that market quality is lower (ie, liquidity is lower and crash risk is higher) in the OTC market than on the traditional exchanges and that it declines monotonically as the OTC market’s information environment deteriorates (ie, moving from the Bulletin Board to the Pink Sheets to the Grey Market). We also document that OTC firms that file disclosures with the SEC or are covered in Mergent’s or Standard & Poor’s securities manuals exhibit higher market quality. In additional tests, we exploit venue transitions, ticker changes tied to changes in SEC filing status, and differential regulatory oversight for financial institutions to provide further evidence that market quality varies systematically across information regimes in the OTC market. Overall, our findings suggest that investors recognize differences in these information regimes and trade accordingly. 

We also analyze whether differences in states’ blue sky laws affect market quality. As state securities laws generally rely on merit reviews by state regulators, the mechanism by which they affect markets is less clear than with federal securities laws, which are based on a disclosure doctrine. Firms’ registration filings with state regulators are generally not easily accessible. The information contained in these filings is therefore unlikely to directly contribute to an increase in market quality. However, merit reviews by state securities regulators could have an indirect effect, eg, by encouraging firms to satisfy blue sky laws via the manual exemption and hence disclosure through manuals or, alternatively, by screening out firms for which concerns about investor protection are more severe. Consistent with this notion, we find that market liquidity is higher for firms located in states with tougher merit review regimes. The results for our other market quality proxy (crash risk), however, are statistically and economically insignificant. To increase our confidence that the liquidity results are indeed related to differences in state securities regulation, we show that the effects are stronger in states that do not allow manual publication to substitute for state registration and merit review. 

Finally, we address the effectiveness of venue-based regulation by analyzing differences in market quality associated with Pink Sheets tiers and information labels. We find that market quality increases monotonically from the lowest to the highest Pink Sheets tier. The Caveat Emptor label is associated with low market quality. These effects are present only for the less regulated non-financial companies, consistent with the results being attributable to the Pink Sheets tiers and information labels. Furthermore, we show that recent Pink Sheets initiatives to improve information availability are associated with increases in market quality. Following the implementation of these regulatory changes, market quality in the Pink Sheets has essentially caught up with that in the Bulletin Board.

In summary, the OTC market is often viewed as unregulated and populated by dark firms when in fact it is a thicket of regulatory regimes at the federal-, state- and venue-level. We exploit this institutional richness to show that market quality increases with stricter disclosure regulation and regulatory oversight. As such, our analysis points to an important trade-off in regulating the OTC market and protecting investors: While lowering regulatory requirements (eg, for disclosure) reduces the compliance burden for smaller firms, it also significantly reduces market liquidity and increases crash risk for investors. 

Ulf Brüggemann is Assistant Professor at Humboldt-Universität zu Berlin, Aditya Kaul is Associate Professor at the University of Alberta, Christian Leuz is Professor at the University of Chicago and Ingrid M. Werner is Professor at Ohio State University.