What Is Watered Stock?
Watered stock referred to shares of a company that were issued at a much greater value than the value implied by a company's underlying assets, usually as part of a scheme to defraud investors. The last known case of watered stock issuance occurred decades ago, as stock issuance structure and regulations have evolved to put a stop to the practice.
This term is believed to have originated from ranchers who would make their cattle drink large amounts of water before taking them to market. The weight of the consumed water would make the cattle deceptively heavier, enabling the ranchers to fetch higher prices for them.
- Watered stock is an illegal scheme to defraud investors by offering shares at deceptively high prices.
- Watered stock is issued at a higher value than it is actually worth by overstating the firm's book value.
- Watered stock, once revealed for what it is, becomes difficult to sell, and if sold, is typically done so at a much lower price than originally obtained.
Understanding Watered Stock
The book value of assets can be overvalued for several reasons, including inflated accounting values—like a one-time artificial increase in inventory or property value—or excessive issuance of stock through a stock dividend or employee stock-option program. Perhaps not in every single case, but often in the late 19th century, owners of a corporation would make exaggerated claims about a company’s profitability or assets, and knowingly sell shares in their companies at a par value that far exceeded the book value of the underlying assets, leaving investors with a loss and the fraudulent owners with a gain.
They would do this by contributing property to the company, in return for the stock of inflated par value. This would cause the value of the company to increase on the balance sheet, even though, in reality, the company would hold far fewer assets than those reported. It would not be until much later that investors learned that they were deceived.
Those holding watered stock found it difficult to sell their shares, and if they could find buyers, the shares were sold at much lower prices than the original price. If creditors foreclosed on the company’s assets, the holders of watered stock could be held liable for the difference between the company’s value on the books and its value in terms of real property and assets. For example, if an investor paid $5,000 for stock that was only worth $2,000, he could find himself on the hook for the $3,000 difference if the creditors foreclosed on corporate assets.
Daniel Drew, cattle driver and financier, is credited with introducing the term to the finance world.
The End of Watered Stock
This practice essentially came to an end when companies were compelled to issue shares at low or no par value, usually under the advice of attorneys who were mindful of the potential for watered stock to create liability for investors. Investors became wary of the promise that par value of a stock represented the actual value of the stock. Accounting guidelines developed so that the difference between the value of assets and low or no par value would be accounted for as capital surplus or additional paid-in capital.
In 1912, New York allowed corporations to legally issue no-par-value stock and split the incoming capital between capital surplus and stated capital on accounting ledgers, with other states following suit shortly thereafter.