Ask TheStreet: In the Pink

Manipulation is the biggest worry for traders playing with penny stocks, and those fears have only grown with the explosion of the Internet. Individual investors and NASD firms have been busted for various schemes involving stocks of small-cap, and even some large-cap, stocks, with the most famous scam being the "pump and dump."

According to the Securities and Exchange Commission, "Pump and dump" schemes, also known as "hype-and-dump manipulation," involve the touting of a company's stock through false and misleading statements to the marketplace. After pumping the stock, fraudsters make huge profits by selling their cheap stock into the market.

"Pump-and-dump schemes often occur on the Internet, where it is common to see messages posted that urge readers to buy a stock quickly or to sell before the price goes down, or a telemarketer will call using the same sort of pitch. Often, the promoters will claim to have 'inside' information about an impending development or to use an 'infallible' combination of economic and stock market data to pick stocks," says the SEC's Web site.

"In reality, they may be company insiders or paid promoters who stand to gain by selling their shares after the stock price is 'pumped' up by the buying frenzy they create. Once these fraudsters 'dump' their shares and stop hyping the stock, the price typically falls, and investors lose their money," the site continues.

Despite all of the problems with penny stocks, there are legitimate companies whose securities trade on the Pink Sheets. In fact, many struggling young companies start out on the Pink Sheets and eventually grow large and profitable enough to jump to a major, national exchange.

It's also worth making the distinction between the Pink Sheets and the OTC Bulletin Board. Companies on the Pink Sheets are not required to meet minimum requirements or file with the SEC, whereas OTCBB companies are required to file current financial statements with the SEC or a banking or insurance regulator.