Watered Stock: What it is and How it Works

What Is Watered Stock?

Watered stock refers to shares issued at a higher value than the company’s underlying assets, often as part of a scheme to defraud investors. However, this practice is now obsolete due to changes in stock issuance regulations.

This term originated from ranchers who would make their cattle drink excessive amounts of water before selling them. The added weight from the water would artificially increase the cattle’s value, allowing the ranchers to sell them at higher prices.

Key Takeaways

• Watered stock is an illegal scheme that deceives investors by offering overpriced shares.
• It involves issuing shares at a value higher than the actual worth, usually by inflating the firm’s book value.
• Once exposed, watered stock becomes challenging to sell and is often sold at significantly lower prices.

Understanding Watered Stock

The book value of assets can be overvalued due to inflated accounting values or excessive stock issuance. In the late 19th century, deceitful owners would make exaggerated claims about profitability or assets, selling shares at a value that exceeded the actual worth. This left investors at a loss and the fraudulent owners with gains.

They achieved this by contributing property to the company in exchange for inflated par value stock. This inflated the company’s value on paper, despite having fewer actual assets. Investors only discovered this deception much later.

Holders of watered stock faced difficulties in selling their shares, and when sold, the prices were significantly lower than the original price. If company assets were foreclosed, these holders could be held responsible for the difference between book value and real property value. For instance, if an investor paid $5,000 for stock worth only $2,000, they could be liable for the $3,000 difference if creditors foreclosed on the corporate assets.

The End of Watered Stock

This deceptive practice was curbed when companies started issuing low or no par value shares, under the advice of attorneys who recognized the liability it created. Investors became cautious of par value as an accurate representation of a stock’s worth. Accounting guidelines were established to account for the difference between asset value and low/no par value as capital surplus or additional paid-in capital.

In 1912, New York legalized the issuance of no-par-value stock, splitting capital between capital surplus and stated capital on accounting ledgers. Other states followed suit shortly after.