a) Watered Stock

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.

Trust fund doctrine is violated when there are watered stocks. Trust fund doctrine simply states that the issuance of watered stock is a fraud on all creditors, and stock-holders will be required to make up the difference between the
purchase price and the par value.
The trust fund doctrine found much criticism among legal scholars, and gradually it fell into disrepute, with only a few states still adhering to it.Many states modified the doctrine
into either the fraud theory or the statutory obligation theory.

b) Trust fund doctrine is a principle of judicial invention which says that corporate assets are held as a trust fund for the benefit of shareholders and creditors and that the corporate officers have a fiduciary duty to deal with them properly. The subscribed capital stock of the corporation is a trust fund for the payment of debts of the corporation which the creditors have the right to look up to satisfy their credits. The creditors can use it to reduce the debts, unless it has passed into the hands of a bona fide purchaser without notice.

The trust fund doctrine usually applies in four cases:

(a) Where the corporation has distributed its capital among the stockholders without providing for the payment of creditors;

(b) where it had released the subscribers to the capital stock from their subscriptions;

(c) where it has transferred the corporate property in fraud of its creditors;

(d) where the corporation is insolvent.