In United Steel Industries (Consideration in Exchange for Stock ), assume that Griffitts’s legal services had been thought by the corporation to be worth $6,000 but in fact were worth $1,000, and that he had received stock with par value of $6,000 (i.e., 6,000 shares of $1 par value stock) in exchange for his services. Would Griffitts be liable for the $5,000 difference between the actual value of his services and the stock’s par value? This is the problem of watered stock: the inflated consideration is in fact less than par value. The term itself comes from the ancient fraud of farmers and ranchers who increased the weight of their cattle (also known as stock) by forcing them to ingest excess water.
The majority of states follow the good-faith rule. As noted near the end of theUnited Steel Industries case, in the absence of fraud, “the judgment of the board of directors ‘as to the value of consideration received for shares’ is conclusive.” In other words, if the directors or shareholders conclude in good faith that the consideration does fairly reflect par value, then the stock is not watered and the stock buyer cannot be assessed for the difference. This is in line with the business judgment rule, discussed in Corporate Powers and Management . If the directors concluded in good faith that the consideration provided by Griffitts’s services accurately reflected the value of the shares, they would not be liable. The minority approach is the true value rule: the consideration must in fact equal par value by an objective standard at the time the shares are issued, regardless of the board’s good-faith judgment.
A shareholder may commence a derivative lawsuit (a suit by a shareholder, on behalf of the corporation, often filed against the corporation; see Corporate Powers and Management ). In a watered stock lawsuit, the derivative suit is filed against a shareholder who has failed to pay full consideration under either rule to recover the difference between the value received by the corporation and the par value.
KEY TAKEAWAY
Corporations may raise funds through the sale of stock. This can be accomplished through an initial public offering (IPO)—the first time a corporation sells stock—or through stock sales after an IPO. The SEC is the regulatory body that oversees the sale of stock. A sale of stock has several benefits for the corporation, such as avoiding the use of debt, which can be much more expensive than selling stock. Stock sales also increase the firm’s exposure and attract investors who prefer more risk than bonds. On the other hand, stock sales have some disadvantages, namely, the dilution of ownership of the corporation. Also, the corporation may undervalue its shares, thus missing out on additional capital because of the undervaluation. Being a publicly traded company places the corporation under the extensive requirements of the SEC and the 1933 and 1934 securities acts, such as shareholder meetings and annual financial reports. The Sarbanes-Oxley Act adds yet more requirements that a corporation may wish to avoid.
Consideration is property or services exchanged for stock. Most investors will exchange money for stock. Certain forms of consideration are not permitted. Finally, a corporation may be liable if it sells watered stock, where consideration received by the corporation is less than the stock par value.
EXERCISES
- Describe the process of conducting an IPO.
- What are some advantages of selling stock?
- What are some disadvantages of selling stock?
- What is consideration? What are some types of consideration that may not be acceptable?
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