Watered stock
Encyclopedia
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 law
s that placed a heavy emphasis upon the par value
of stock
.
, a cattle driver turned financier.
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.
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
with an artificially-inflated
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
value. The term is most commonly used to refer to a form of securities fraud
Securities fraud
Securities fraud, also known as stock fraud and investment fraud, is a practice that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in losses, in violation of the securities laws....
common under older corporate law
Corporate law
Corporate law is the study of how shareholders, directors, employees, creditors, and other stakeholders such as consumers, the community and the environment interact with one another. Corporate law is a part of a broader companies law...
s that placed a heavy emphasis upon the par value
Par value
Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par , over par and under par ....
of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
.
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 DrewDaniel Drew
-Biography:He was born in Carmel, New York.Drew was poorly educated. His father died when Daniel was fifteen years old. Drew enlisted and drilled, but because he enlisted too late, never fought in the War of 1812. After the war, he started a successful cattle-driving business. In 1823, he married...
, 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 bondsBond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
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
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
, the property would be the corporation's only capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
, 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
Capital surplus
Capital surplus term that frequently appears as a balance sheet item as a component of shareholders' equity. Capital surplus is used to account for that a firm raises in excess of the par value of the shares ....
, 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.