by Tom Stilp JD, MBA/MM, LLM, MSC, DBA
November 1st, 2024
Have you ever wondered why a corporation cannot issue stock to its President in return for a promise to work for a year without salary? Or issue stock in exchange for a promissory note signed by the President of the Company(even if the President is wealthy and able to pay)? The answer is historical. The law takes a paternalistic view to protect the corporation.
Known as “watered stock,” a corporation that issues stock for property or cash less than the value of the stock adversely impacts the balance sheet. In other words, with watered stock, the perceived value of a company’s stock is artificially inflated because the company did not actually receive the Paid-In Capital stated on its books. Assuming a promissory note for $100 for 1,000 shares ($100,000) at a “par value” of $1 for each common share (the minimum
value that must be paid per share), the balance sheet might look something like the following:
But in reality, the company only received $1,000 and a $99,000 promissory note, which has yet to be paid.
The term, “watering the stock,” came from a deceptive practice in the cattle business. Ranchers would feed salt to the cattle the night before the cattle were sold at market. The cattle would drink a lot of water and weigh more the next day at market, resulting in higher prices for the ranchers.
If the law’s paternalistic view to protect the corporation was ever correct, it is probably irrelevant today as creditors review multiple sources of information to determine a company’s solvency and ability to pay. A few states have even moved away from “par value” of stock, “Paid-In Capital” or “Capital Surplus,” and now recognize promissory notes and the promise of future services as a “benefit to the corporation.” ABA Revised Model BusinessCorporation Act, §6.21 (2024).
Nonetheless, cases of overreach exist. In our law practice, we have filed lawsuits on behalf of creditors and shareholders where watered stock has led to an overvaluation of assets, misleading accounting, and a finding of fraud when a company has presented an overly optimistic view of its financial health.
References
American Bar Association. Committee on CorporateLaws. (2024). Model business
corporation act : Official text with official comment and statutory cross-references, revised through June2005. Chicago, IL :Section of Business Law, American Bar Association.
This article was written in part with https://askaichat.app/chat/1729786548674
This article is based on Klein, W., Coffee, J. and Partnoy, F. (2010). Business organization
and finance: Legal and economic principals (11th ed.). Thomson Reuters/Foundation Press, pp. 225-230.
