What Is Watered Stock?

Livestock watering was a common practice in the 1800's.

Watered stock, also called bonus or discount stock, is a type of investment traders sell at a price greater than its actual value, according to Deborah E. Bouchoux in her book "Business Organizations for Paralegals." Simply put, watered stock is stock issued for overvalued services or property, so that their true value is less than par value.

Background and Origin of the Term

The "stock watering" fraud common in the 18th and 19th century American livestock business lays the concept of watered stock. Cattle were made to drink water just before sale and the excess water showed them as weighing more than they actually did. This drove their prices up. The financial background of the term is credited to Daniel Drew, a mid-19th century cattle drover turned stock speculator. Applying the same principle of livestock watering to corporate stock, Drew would issue stock at a value higher than a company's economic value. The difference between the actual and issued value of the stock was called "water." Similar to his cattle, the stock appeared at the offset to have greater value than its actual worth.

Watered Stock and Overcapitalization

Watered stock results in overcapitalization -- shortage of capital in a company. The turn of the 20th century saw the practice of overcapitalization in full swing. It was a common way to cause monopolies and create large amounts of illusory securities that led to economic instability and corporate mismanagement. It was also the most widely used way to create and sell new securities on the market, according to Lawrence E. Mitchell in the book "The Speculation Economy: How Finance Triumphed Over Industry." However, its widespread use and ensuing antitrust and economic instability forced the industry to establish regulations and laws corporations were required to adhere to.

Legal Issues

Issuing shares below par value is legal in the United States. However, the practice is illegal if the issuing company acts fraudulently or in bad faith and withholds information with respect to the reasons for the issue.

Problems

According to Lawrence E. Mitchell, the practice of stock watering ensued serious economic and antitrust problems by facilitating overcapitalization. Shareholders are personally liable for their purchased watered stocks and must pay their difference to the issuing corporation.

Example

Stock watering contributed to the fall of Enron, the American energy giant. The company issued shares of stock without having enough tangible assets to back the issuance, leaving hundreds of thousands of investors holding worthless stock.

References

• "The Speculation Economy: How Finance Triumphed Over Industry"; Lawrence E. Mitchell; 2007
• "Business Organizations for Paralegals"; Deborah E. Bouchoux; 2009
• "Bulls, Bears, Boom, and Bust"; John M. Dobson; 2007
• New York Times: Watered Stock