What are penny stocks?
Penny stocks are low-priced shares of very small companies, and under federal securities law the label carries specific rules, not just a casual description of a cheap stock. The Securities and Exchange Commission defines a "penny stock" as an equity security trading below five dollars a share that doesn't qualify for one of several exclusions, such as being listed on a national securities exchange, and that definition triggers extra disclosure and suitability obligations for the broker-dealers who sell them, under 
SEC Exchange Act Rule 3a51-1. Most penny stocks trade over-the-counter rather than on major exchanges, are thinly traded, and publish little public information, which makes them attractive targets for manipulation and hard for ordinary investors to research, according to the SEC's 
Investor.gov microcap fraud page. The category overlaps heavily with what regulators call microcap stocks — low-priced shares of companies with very small market value — and the SEC treats the two terms as closely related in its investor education materials, per the same microcap fraud guidance. Because of the fraud risk and illiquidity involved, federal regulators repeatedly warn that penny stocks are highly speculative and that investors should approach them with particular caution, as noted on Investor.gov's stocks overview.
How the SEC defines and regulates them
The SEC's penny stock rules, most recently amended in 2005, updated the definition of "penny stock" and the information broker-dealers must give customers to reflect changes in markets and communications technology, under the Amendments to the Penny Stock Rules, Release No. 34-51983, effective September 12, 2005. In practice, a stock generally falls under these rules when it trades below five dollars a share and is not listed on a national exchange like the NYSE or Nasdaq; exchange-listed shares and certain other categories are excluded even if priced under five dollars. Because these securities can be traded on interdealer quotation systems, the SEC has separately designated systems such as FINRA's OTC Reporting Facility as qualifying quotation systems for purposes of the penny stock definition, as described in the FINRA OTC Reporting Facility designation. The rules exist because penny stocks sit outside the disclosure and liquidity standards that apply to exchange-listed companies, leaving investors with far less independently verified information to rely on.
Why they're considered risky
Public information about penny stock companies is often scarce, and the shares are frequently illiquid and traded off the national exchanges, conditions that make false statements and price manipulation easier to pull off, according to Investor.gov's microcap fraud page. SEC staff research examined roughly 10,000 over-the-counter stocks trading between 2013 and 2015, involving more than 200 billion dollars in annual volume, and found that returns for individual investors were severely negative on average, with worse outcomes tied to promotional campaigns and weaker company disclosure, and the poorest results concentrated among older, retired, lower-income, and less-educated investors, per the SEC Division of Economic and Risk Analysis white paper on outcomes of investing in OTC stocks. Warning signs the SEC flags include unsolicited or unusually heavy promotion, companies with no real business operations, unexplained spikes in price or trading volume, an SEC trading suspension, frequent name or business-plan changes, and shares that only trade over-the-counter rather than on a registered exchange, all listed on the microcap fraud page. The SEC also maintains a public list of stocks it has suspended from trading, which investors can check directly.
Pump-and-dump schemes and fraud
A common scheme built around penny stocks is the pump-and-dump: promoters spread false or misleading claims, sometimes hinting at inside information about positive company news, to drive up a thinly traded stock's price, then sell their own shares once the price rises, according to Investor.gov's explanation of pump-and-dump schemes. These promotions can show up in social media, email blasts, newsletters, chat rooms, direct mail, or even radio and print ads, and disclosed compensation for touting a stock does not make the promotion legitimate. The SEC and FINRA have jointly warned that aggressively promoted penny stocks sometimes involve dormant shell companies revived specifically to be pumped and dumped, and they advise checking a company's filing history in EDGAR, watching for extreme reverse stock splits, and treating a fifth-letter "Q" in a ticker symbol as a signal the company may be in bankruptcy. Once the promoters stop hyping the stock and sell, the price typically collapses, leaving remaining shareholders holding shares worth far less than they paid, per the pump-and-dump alert.
Checking a company and reporting problems
Before looking at any penny stock, investors can pull up a company's actual filings — or confirm it has none — through the SEC's EDGAR company search, and can check whether a broker or investment professional is properly registered using Investor.gov's search tool. Anyone who suspects a penny stock promotion is fraudulent can report it through the SEC's Tips, Complaints and Referrals Portal, or file a complaint about a broker or brokerage firm using the SEC investor complaint form. There is also a live petition asking the SEC to consider new rules that would bar national exchanges from listing certain high-risk penny stocks and require added issuer disclosures, which the public can review and comment on through the SEC's rulemaking petition page. None of this is investment advice about whether to buy or avoid any particular stock — it's simply where to verify the facts before deciding.