Watered stock refers to shares of a company issued at a deceptively greater value than the real value reflected by the company’s assets, often exploited as part of fraudulent schemes. This unethical practice has been phased out due to today’s stringent stock issuance structures and regulatory standards.
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.
Key Takeaways
- Watered stock is an illegal scheme defrauding investors by issuing shares at misleadingly high prices.
- Overvalued stock is presented at exaggerated worth through overstated asset values or excessive stock issuance schemes.
- Once uncovered, watered stock becomes difficult to sell and is typically sold at values substantially lower than the initial purchase price.
Unveiling Watered Stock:
In historical contexts, corporations might inflate their book value through manipulated accounting practices—such as surging inventory or property values artificially—or through excessive stock issuance programs. In the late 19th century, unscrupulous owners exaggerated corporate profitability or assets and sold shares at an inflated par value, misguiding investors to make profits for themselves.
Owners accomplished this by contributing property at artificially increased valuations in exchange for shares of inflated par value. This falsely elevated the company’s value on the balance sheet, while the actual asset base remained much lower, misleading investors.
When investors discovered the deception, the difficulty of selling watered stock was apparent. If sales occurred, it was at values dramatically lower than initial purchases. In cases of creditor foreclosure, holders of watered stock were liable for discrepancies between inflated book value and true asset value. For example, if an investor paid $5,000 for stock worth only $2,000, they were liable for the remaining $3,000 upon foreclosure.
The term watered stock was popularized by Daniel Drew, a financier and cattle driver, by introducing the concept in the financial realm.
The End of Watered Stock:
The exploitation of watered stock concluded as companies were urged to issue shares at low or zero par value, often based on legal advice to mitigate investor liability for fraudulent stock prices. Investors learned to distrust par value representations and regulatory guidelines ensured asset value differentiation could be recognized as capital surplus or additional paid-in capital.
In 1912, New York initiated legislation enabling corporations to issue no-par-value stock, partitioning incoming capital between capital surplus and stated capital, a practice rapidly adopted by other states soon afterwards.
Related Terms: stock value, capital surplus, par value, no-par-value stock, additional paid-in capital.
