![Erie_Railroad_Company,_common_capital_stock,_1869](https://upload.wikimedia.org/wikipedia/commons/f/fb/Erie_Railroad_Company%2C_common_capital_stock%2C_1869.jpg)
Watered stock is an
asset
In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
with an artificially-
inflated value. The term most commonly refers to a form of
securities fraud
Securities fraud, also known as stock fraud and investment fraud, is a deceptive practice in the stock or commodities markets that induces investors to make purchase or sale decisions on the basis of false information, frequently resulting in los ...
in which a company issues
stock
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
to someone before receiving at least the
par value
Par value, in finance and accounting, means stated value or face value. From this come the expressions at par (at the par value), over par (over par value) and under par (under par value).
Bonds
A Bond_(finance), bond selling at par is priced at 1 ...
in payment.
[Dodd, David L. ''Stock Watering: The Judicial Valuation of Property for Stock-Issue Purposes''. New York: ]Columbia University Press
Columbia University Press is a university press based in New York City, and affiliated with Columbia University. It is currently directed by Jennifer Crewe (2014–present) and publishes titles in the humanities and sciences, including the fiel ...
, 1930.
Origin of term
"Stock watering" was originally a method used to increase the weight of livestock before sale. The cattle were first given
salt
Salt is a mineral composed primarily of sodium chloride (NaCl), a chemical compound belonging to the larger class of salts; salt in the form of a natural crystalline mineral is known as rock salt or halite. Salt is present in vast quantitie ...
to make them thirsty, then allowed to drink their fill of water. The term's introduction to the New York financial district is popularly credited to
Daniel Drew
Daniel Drew (July 29, 1797 – September 18, 1879) was an American businessman, steamship and railroad developer, and financier. Summarizing his life, Henry Clews wrote: "Of all the great operators of Wall Street ... Daniel Drew furnishes th ...
, a cattle driver turned financier.
Explanation
![Harroun_Motors_1917](https://upload.wikimedia.org/wikipedia/commons/4/44/Harroun_Motors_1917.jpg)
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
In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
, the property would be the corporation's only
capital
Capital may refer to:
Common uses
* Capital city, a municipality of primary status
** List of national capital cities
* Capital letter, an upper-case letter Economics and social sciences
* Capital (economics), the durable produced goods used f ...
, 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 have only $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
Foreclosure is a legal process in which a lender attempts to recover the balance of a loan from a borrower who has stopped making payments to the lender by forcing the sale of the asset used as the collateral for the loan.
Formally, a mortg ...
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 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 high par values could create liability for investors if the corporation went into bankruptcy, 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, also called share premium, is an account which may appear on a corporation's balance sheet, as a component of shareholders' equity, which represents the amount the corporation raises on the issue of shares in excess of their par v ...
, 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 the 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.
Examples
* In 1866–1868, during the so-called
Erie War
The Erie War was a 19th-century conflict between American financiers for control of the Erie Railway Company, which owned and operated the Erie Railroad. Built with public funds raised by taxation and on land donated by public officials and priva ...
,
Cornelius Vanderbilt
Cornelius Vanderbilt (May 27, 1794 – January 4, 1877), nicknamed "the Commodore", was an American business magnate who built his wealth in railroads and shipping. After working with his father's business, Vanderbilt worked his way into lead ...
was defrauded by
James Fisk,
Daniel Drew
Daniel Drew (July 29, 1797 – September 18, 1879) was an American businessman, steamship and railroad developer, and financier. Summarizing his life, Henry Clews wrote: "Of all the great operators of Wall Street ... Daniel Drew furnishes th ...
and
Jay Gould
Jason Gould (; May 27, 1836 – December 2, 1892) was an American railroad magnate and financial speculator who is generally identified as one of the robber barons of the Gilded Age. His sharp and often unscrupulous business practices made hi ...
, who sold $7,000,000 worth of watered stock to him in his attempt to acquire the
Erie Railroad
The Erie Railroad was a railroad that operated in the northeastern United States, originally connecting New York City — more specifically Jersey City, New Jersey, where Erie's Pavonia Terminal, long demolished, used to stand — with Lake Erie ...
.
* In 1873, the Railway Commissioners of Illinois reported that the stock of the railway companies in the state was inflated to $75,000,000, bringing $6,000,000 in yearly profits. In particular, the investigation uncovered that 75% of the Central Pacific Company's assumed capital was fictitious.
* The last significant watered stock claim in American law occurred in 1956. In that case, the
Minute Maid
Minute Maid is a product line of beverages, usually associated with lemonade or orange juice, but which now extends to soft drinks of different kinds, including Hi-C. Minute Maid is sold under the Cappy brand in Central Europe and under the bran ...
company (then part-owned by its pitchman,
Bing Crosby
Harry Lillis "Bing" Crosby Jr. (May 3, 1903 – October 14, 1977) was an American singer, musician and actor. The first multimedia star, he was one of the most popular and influential musical artists of the 20th century worldwide. He was a ...
) attempted to recover debts directly from the owner of a distribution business on the basis that he had never fully paid the $45,000 par value of his stock.
Criticism
The practice of watered stock was sharply criticized by members of the
Social Gospel
The Social Gospel is a social movement within Protestantism that aims to apply Christian ethics to social problems, especially issues of social justice such as economic inequality, poverty, alcoholism, crime, racial tensions, slums, unclean envir ...
movement such as
George D. Herron
George D. Herron (January 21, 1862 – November 9, 1925) was an American clergyman, lecturer, writer and Christian socialist activist.
Herron is best remembered as a leading exponent of the so-called Social Gospel movement and for his highly publ ...
and
Walter Rauschenbusch
Walter Rauschenbusch (1861–1918) was an American theologian and Baptist pastor who taught at the Rochester Theological Seminary. Rauschenbusch was a key figure in the Social Gospel and single tax movements that flourished in the United States d ...
.
For example, in 1898, Herron said "watered stock is a method of high treason by which corporations forcibly tax the nation for private profit, and by which they annually extort millions from American toilers and producers. It is... essentially a system of violence, spoil, and robbery."
See also
*
David Dodd
David LeFevre Dodd (August 23, 1895 – September 18, 1988) was an American educator, financial analyst, author, economist, and investor. In his student years, Dodd was a ' and colleague of Benjamin Graham at Columbia Business School.
The Wall ...
*
Daniel Drew
Daniel Drew (July 29, 1797 – September 18, 1879) was an American businessman, steamship and railroad developer, and financier. Summarizing his life, Henry Clews wrote: "Of all the great operators of Wall Street ... Daniel Drew furnishes th ...
*
Counterfeiting
To counterfeit means to imitate something authentic, with the intent to steal, destroy, or replace the original, for use in illegal transactions, or otherwise to deceive individuals into believing that the fake is of equal or greater value tha ...
References
{{Corporate finance and investment banking
Equity securities