e. Watered Stock 2. General circumstances in watered stock can arise.

A company can exchange capital stock for assets valued at less than the stocks par value. This transaction artificially inflates the value of the exchange assets. The stock of a corporation is sometimes watered by the officers or a few large stockholders for their own benefit. They represent that it is necessary to largely increase the capital stock of the company in order to enlarge the plant, etc. After the increase has been voted by the stockholders and authorized, the few who are manipulating the deal make a loan to the company and take the new stock in abundant quantity as security. Of course there is a default in the payment of the loan when due and the stock becomes the property of the lenders. In the case of many corporations of a speculative character the stock consists largely of water from the first, the actual assets bearing a small proportion to the capitalization of the company. The officers and promoters sell the stock to outsiders until they have secured sufficient money to conduct the enterprise, and retain the balance (usually a large portion) for themselves. This is termed "getting in on the ground floor." Of course watering stock is an illegal proceeding, usually engaged in for the purpose of deceiving the public, and may be punished by the revocation of the company's charter. But an increase of the capital stock above the tangible assets to a point which will include the value of the franchise or "good will" is perfectly legitimate, for the latter may be the most valuable asset of the company. Corporations are sometimes inclined to place a very large valuation upon the "good will" or franchise, especially if they are earning large dividends, owing to the prejudice in the public against larger dividends than the usual rate of interest on loans. A firm may earn 10 or 15 per cent. upon its capital and nothing is said or thought of it, but if that firm should organize into a corporation and earn the same profits, it would be severely condemned by public opinion. Public sentiment is therefore a constant pressure upon corporations to drive them to stock watering. Money earned by a corporation over and above its expenses remains the property of the company until the directors declare a dividend, when it becomes the property of the individual stockholders. The company may then distribute the entire net earnings as dividends or it may reserve part of the earnings of a prosperous year to make up for possible lack of profits in future years, or it may invest a portion of its net earnings in improvements of the plant and distribute the remainder as dividends. Again it may, by vote of the stockholders, declare a stock dividend, that is, a dividend payable in stock

instead of cash. This is equivalent to an increase of the capital stock of the company and must be certified to the Secretary of State. A stock dividend is perfectly legitimate and proper when the entire net earnings of the business are needed to improve the plant, thereby increasing its value to correspond with the increase of the capital stock.* When stock is sold the dividend goes to the buyer, unless otherwise agreed, and unless the dividend has been declared. If the dividend has been declared it becomes in a sense separated from the stock and is the personal property of the one who owned the stock at the time it was declared. Fictitious dividends are those which are supposed to be earned by the company, but are really paid out of the capital or from borrowed money. The object is to deceive stockholders into believing that the company is prosperous when it is not, thereby inducing them to purchase more stock or persuade their friends to do so. When stockholders become suspicious false statements are made as to the earnings, expenses, value of the franchise, etc., and thus they are quieted, while the manipulators of the company's affairs * perhaps are selling out or "unloading" their stock quietly, at a good price, leaving the corporation wrecked. In rare instances, however, fictitious dividends may be justifiable. Thus when a succession of prosperous years is followed by one of disaster and loss, after which the business promises good returns again, it may be proper to continue the same dividends through the bad year, rather than destroy the regularity of them to stockholders. An illustration of this policy is the Chicago, Burlington & Quincy Railroad Company. In 1888 the company suffered severely on account of a strike among its locomotive engineers. Though frankly admitting that no dividends were earned that year, The Company paid the usual dividend rather than disturbed the value of its stock and disappoint shareholders. Under the circumstances this was justifiable.  The issuance of a stock dividend, although in many respects analogous to stock watering, is not open to the same objection, since the issuance of the additional stock does not involve a marking up of the book value of the company's assets beyond their actual value. Some of the best managed companies pursue the policy of paying very small cash dividends and capitalizing their surplus accumulations in this way from time to time, thus keeping most of the earnings in the business while giving the stockholders what amounts to a fair return on their investment.  Corporations are not permitted in law to declare and pay dividends upon stock when their assets, at a fair valuation, are not sufficient to pay their outstanding

indebtedness to creditors in full, and if directors and officers of a corporation knowingly declare and pay dividends under such circumstances, they are generally held individually liable for all of the existing debts and obligations of the corporation and those subsequently contracted. The payment of such dividends is considered a fraud -and has in instances been indulged in to procure to the stockholders assets of the corporation which should have gone to the payment of corporate indebtedness. As long as the corporation is solvent and has ample assets with which to discharge its existing indebtedness, there is usually no restraint upon paying dividends, though unearned. This is a dangerous proceeding, at all events, and the creditors, whose obligations have accrued subsequent to the payment of such dividends, are, under some circumstances, permitted to recover from the stockholders the dividends so paid, when subsequent insolvency demonstrates that the capital was impaired by such payment of dividends, and suspension of business and failure followed. The surplus fund, reserve fund, or sinking fund is the accumulation of a portion of the net profits of the corporation set aside each year as a contingent fund to liquidate a debt, meet reverses or enable the company to declare a uniform rate of dividend whether the earnings are uniform or not. For the purpose of marketing the stock and avoiding the fluctuations in value which would be caused by a fluctuating dividend, the surplus fund is created, and if the net earnings should fall below the usual minimum dividend limit, the surplus is then drawn on for the deficiency. This enables the company to declare a uniform dividend, gives better satisfaction to the stockholders, who know about what dividends to expect, and makes the stock much more salable and desirable to investors. A sinking fund may be created to meet an outstanding obligation falling due at some future date. If it is a bond issue, the deed of trust given as security for the bonds usually provides that a certain sum shall be set apart out of the net profits and paid to the trustee. The trustee then invests these sums in the company's bonds of the issue to be retired, or any other issue of the company, according to the provisions of the trust deed, and these are held in trust until the final settlement, when the matured bonds are canceled and returned to the corporation. The trust deed may provide that the trustee is to invest the sinking fund in bonds of other companies or it may be left to his discretion.

3. Steps can be taken to eliminate water from a capital structure Watering stock consists in increasing the amount of stock issued beyond the value of the assets of the corporation. It is an art in which the present generation seems to have become expert, and by means of its clever manipulation great "operations" have been financed, to the enrichment of the manipulators. By watering its stock it manages to keep the percentage of earnings below the limit and thus avoids payment of the excess rightfully due to the municipality. Several factors combined to effectively eliminate the watered stock problem. One was the decline of par value as a meaningful concept. Par value always was an arbitrary figure. With the development of secondary trading markets for corporate stock, the market price (and thus the value) of outstanding corporate stock rarely coincided with its par value. As a result, par value simply had no relation whatsoever to the price shares would command on a secondary trading market or the price at which shares subsequently might be issued by the corporation. States began to permit corporations to issue low par value stock (such as shares with par value) and most states eventually permitted corporations to issue shares having no par value. Consequently, today, watered stock is largely a dead issue. Corporations issue no par or low par stock and sell it at the highest price the shares will bring in the primary market. As long as the investor pays something for his shares, the par value requirement will be satisfied.