Watered stock

Watered stock

Watered stock is an asset with an artificially-inflated value. The term is most commonly used to refer to a form of securities fraud common under older corporate laws that placed a heavy emphasis upon the par value of stock.

Origin of term

"Stock Watering" was originally a method used to increase the weight of cows before sale. It entailed forcing a cow to bloat itself with water before it was weighed for sale. Its introduction to the New York financial district is popularly credited to Daniel Drew, a cattle driver turned financier.

Explanation

American stock promoters in the late 1800s could inflate their claims about a company's assets and profitability, and sell stocks and bonds in excess of the company's actual value. To do so, they would contribute property to a new corporation in return for stock at an inflated par value. On the balance sheet, the property would be the corporation's only capital, and because legal capital was fixed to aggregate par value, the value of the property would go up. While the promoter had $10,000 in stock, the corporation might only have $5,000 worth of assets, but would still be worth $10,000 on paper.

Holders of watered stock could be personally liable if creditors foreclosed on the corporation's assets. If they had received $10,000 in stock for a $5,000 capital contribution, they would not only lose their $5,000 investment but would also be personally liable for the additional $5,000, whether they were the aforementioned promoter lying about the value of their contribution, or an innocent investor relying on par value to gauge the true value of the corporation.

Because par value was such an unreliable indicator of the actual value of stock, and because high par values could create liability for investors if the corporation went belly up, corporate lawyers began advising their clients to issue stocks with low par values. The legal capital or "stated capital" of the corporation would still be determined based on par value, but the balance sheet would include the investment over par value as a capital surplus, and everything would still balance.

In 1912, New York authorized corporations to issue "no par stock" with no par value at all, in which case the board of directors would allocate the incoming capital between stated capital and capital surplus. All other states followed suit. Thanks in large part to a proliferation of low par and no par stock, watered stock is less of an issue these days. The last major American court case dealing with watered stock was in 1956.

References

Dodd, David LeFevre, "Stock Watering: the judicial valuation of property for stock-issue purposes"(January 1, 1930), Columbia University Press

ee also

David Dodd


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