The Moral Aspect of Commercial “stockwatering”

In the number of The American Ecclesiastical Review for December, 1907, the Rev. J. A. Ryan complained that the ethics of business did not receive adequate treatment in the current manuals of Moral Theology. Among the questions which he singled out as either receiving no attention at all or not sufficient attention he instanced “ stockwatering, and its manifold causes, characteristics, and effects.”¹ I propose in this paper to make an attempt to supply the deficiency of the text-books in this particular respect.

¹ Page 653.

It seems to me that the main difficulty in these questions for the moralist is to get a clear idea of the operation in question. If he can do this, his knowledge of the general principles of justice and charity will enable him to decide whether the operation is morally wrong or not. However, the difficulty is a real one, for the ordinary student of moral theology is not a business man, and he cannot be expected to know all the latest devices by which rogues and swindlers strive to attain their ends. By the time that any particular device is sufficiently well known to be inserted in a text-book of moral theology it will of course so far be useless for the purposes of the swindler, who will abandon it for less obvious and more efficient methods. In spite of this, however, it may be worth while to discuss the morality of stockwatering, for even devices that are hoary with age are often successful still, and the borderland between the operation that may be permitted and what must be forbidden is not always obvious.

To water stock then is, as the Century Dictionary tells us, to increase the nominal capital of a corporation or company by the issue of new shares without a corresponding increase of actual capital. Stockwatering then is an operation connected with the working of joint-stock companies. Most modern States have what are called in England Company Acts, and in the United States Corporation Laws, which enable a number of people who conform to the regulations laid down to constitute themselves into a corporate body for some definite object, with definite legal rights and obligations distinct from those of the individual members of the corporation. A joint-stock company usually owes its existence to the enterprise of the promoter. He hears of a mining property or of a printing business which is for sale, and obtains a contract or an option from the owner. He procures the requisite number of persons to sign the Memorandum and Articles of Association and registers the documents with the Registrar of Joint-stock Companies. After these preliminaries have been duly executed, the certificate of incorporation is issued and the new company is born to work the mine or to manage the printing business. A prospectus may then be issued describing the objects of the new company and inviting the public to subscribe for shares and become partakers of its fortunes. The Memorandum of Association is the charter of the new company and, besides other matters, it must contain a statement of the amount of capital with which the company is registered divided into shares of a certain fixed amount. The amount of capital mentioned in the memorandum is the nominal capital of the company and may be widely different in amount from its actual capital. Thus the promoter of a banking business who wishes to impress the public with the idea of the vast scale on which it is proposed to transact business, may put down $10,000,000 as the capital of the company, divided into shares of $50 each. It may happen that only ten shares are issued and that these are only half paid up. Thus although the nominal capital of the company is $10,000,000, its actual capital is only $250.

We have described in rough outline the formation of a joint-stock company according to English law and although the details of American law differ somewhat from the above, still the broad features are similar, and what has been said will suffice for our purpose. This much concerning the flotation of companies had to be premised, for it is precisely in this matter of nominal capitalization that stockwatering and over-capitalization takes place. Authorities are not quite agreed as to what should be the norm for regulating the amount of a company’s capital. The question is of special importance in those States which have legislated against over-capitalization ; there especially it is necessary to have a recognized standard for the legal capitalization of corporations. But what is that standard to be? Is it to be the total original cost of the undertaking and actual investment from the outset; or what it would cost to replace the plant under present conditions; or the structural value, value, that is, for service and wear; or the market value of the enterprise if it were sold in open market; or, finally, its earning capacity? To show how widely estimates may vary according as one or other of these standards is taken as the basis of reckoning, we quote from Mr. W. Z. Ripley, Professor of Political Economy at Harvard, the leading case of the Interstate Consolidated Railroad Company. Professor Ripley says:

Operating both in Rhode Island and Massachusetts, it had obtained a charter from the former State with the right to issue stock and bonds to the amount of $650,000. It then applied to the Railroad Commission for authority to issue this amount under the Massachusetts charter as well. The original capitalization of a defunct predecessor had been $875,000, of which only about $470,000 represented the actual investment, the remainder being water. Owing to the fall in prices of electrical equipment, it was established that the plant could be duplicated for about $400,000. Its present structural value was estimated to be not over $255,000, while the price paid for it at public auction by its then present holders was $152,000. Excluding the possible basis of capitalization upon earning capacity, which ranged upon estimate from nothing to $900,000, which of these other standards, between $470,000 and $152,000, ought rightly to be applied?³ German Company Law adopts the first of these, the original and total cost, as the legal standard of capitalization. At first, as Mr. Ripley shows, Massachusetts adopted the same standard. It was felt, however, that there were grave objections against this method. Large sums of money were sometimes spent foolishly or even dishonestly in floating companies; large expenditure was often incurred in “kissing” bills through legislatures. Sometimes fancy prices have to be paid for vested interests, or in the consolidation of companies — become necessary for effective working — small local undertakings have to be bought out at exorbitant rates. As Mr. Ripley says:

³ Trusts, Pools, and Corporations, p. 130 (1905).

These fundamental objections against original investment as a basis for capitalization have led to general acceptance of the cost of present reproduction in its place. This is the norm usually accepted by judicial appraisers, as in the recent case still pending in the courts, concerning purchase by the city in 1895 of the Newburyport waterworks. It seems to have been adopted also in appraisal of the Milwaukee street railroads in 1898 as well as in Detroit. It is the one recognized by the Massachusetts Railroad commissioners in their regulation of capitalization. The Gas and Electric Light commissioners in the same State also adhere to it closely in fixing the price of product.³

³ Loc. cit., p. 133.

English opinion favors the estimated earning capacity of the undertaking as a basis for capitalization. If the undertaking will give a fair and reasonable interest on the money sunk in it so that the reasonable expectations of the shareholders who bought shares are not disappointed, it is thought that there can be no question of over-capitalization. A moralist would have no difficulty in approving any one of these recognized standards as a basis for capitalizing a company. Provided that the shareholders get fair value for what they contribute according to their reasonable expectations, and the creditors of the company, if there are any, are not wronged, and no harm is done to others, it is a matter of indifference to the moralist what may be the basis of capitalization. The moralist of course cannot tolerate over-capitalization, or capitalization largely in excess of what is right and proper according to any fair standard whatever. The practical evils of over-capitalization which make it necessary for the moralist to condemn the practice may be summed up in the words of Professor Ripley. He says:

Over-capitalization is one of the most frequent, time-honored and persistent charges brought against industrial combinations and against corporations particularly as distinct from other forms of business organization. The general public avers, in behalf of its interest as consumer, that while of course there is no direct relation between capitalization and prices, an excess of securities craving dividends is in itself an indirect incentive to unreasonable charges. An even more cogent objection than this is that the absence of any direct relation between investment value and the volume of stocks and bonds confuses all parties concerned. This was an underlying motive in the enactment of the Massachusetts Anti-Stock-Watering Laws of 1894. For a divergence between the actual property value and capitalization may lead to exorbitant prices and dividends at the expense of the public. It invites unearned profits on the part of promoters leading to corporate organization or financial readjustment in unnecessary or unmerited instances. It stimulates extravagance on the part of banking syndicates in the prices offered or paid for constituent companies. It facilitates internal mismanagement, even promotes actual fraud, by the ease with which the most alert stockholders may be confused as to the real standing of their own company. And finally it invites speculation and stock market jobbery among the public by the relatively small capital necessary to deal in, or acquire control of, considerable blocks of stock.⁴

⁴ Loc. cit., p. xxiii,

Moreover, when a concern is largely over-capitalized its real value is obscured and there is no adequate security either for the creditor or for the shareholder. A few large dividends of an inflated company are no adequate security for the creditor; he must rest for his final security on the permanent and real value of the concern. It is obvious that the shareholders who have contributed their money in ignorance of the wide difference between the nominal and the actual capital of the concern are wronged, for only the actual capital can furnish them with the dividends, the expectation of which induced them to purchase shares. We are now in a position to study the morality of stockwatering in particular cases.

English law permits the promoter of a company to fix the nominal capital at any figure he pleases. A fee which rises progressively with the amount of capital must indeed be paid on registration, but the smallness of this fee is but a slight obstacle in the way of an enterprising promoter who for one reason or another over-capitalizes his company. The same is practically true of many of the States of the Union. To quote again from Professor Ripley:

Among our American commonwealths the most flagrant examples of unlimited capitalization occur under the laws of West Virginia, Delaware, and New Jersey. In the first of these no limitation whatever is placed upon stock issues beyond payment of a small registration tax. The Delaware constitution follows the usual statutory enactment of other States, prohibiting all issues of stock except for money paid, labor done, or property actually received. The absence of all administrative control, and the apparent failure of the State courts to rule adversely, naturally renders this law of no effect. New Jersey has met the issue adroitly. Its Corporation Act, as revised in 1896, recites that ‘‘nothing but money shall be considered as payment of any part of the capital stock’’; except that any corporation may purchase property by the issue of securities, in which case ‘‘the judgment of the directors as to the value of the property purchased shall be conclusive.’’⁵

⁵ Loc. cit., p. 122.

We have seen what standard Massachusetts adopts for the legal capitalization of public service corporations; for business corporations the Massachusetts Business Corporation Law, 1903, adopted the theory that “so long as incorporators are not acting fraudulently they may capitalize any property, tangible or intangible, at any amount they desire, provided that no stock may be issued at or after organization until a statement has been prepared and placed upon public record, showing the amount of stock which has been issued and the exact manner in which it is paid for.”⁶ Similarly, the English Companies Act, 1900, relies on publicity as a safeguard against over-capitalization. By that Act the prospectus of any company, which offers shares to the public for subscription, must among other things contain “ the names and addresses of all vendors of property purchased by that company, together with the amount payable in cash or shares to the vendor, and where there have been a succession of vendors, then the amount paid to each; the amount payable for good-will (a frequent excuse for concealed fraud) is to be set out particularly: the sum paid as commission for procuring subscriptions, for preliminary expenses, and generally anything paid to the promoter must also be clearly specified, and, finally, the dates and parties to every material contract entered into during the previous three years, not being a contract made in the ordinary course of business, must be set out, together with the place where such contracts may be inspected.’’⁷ These provisions are hardly adequate to protect investors against the evil of stockwatering. A common practice of company promoters is thus described by Mr. Montague Barlow in the volume from which we have already quoted:

⁶ W. Z. Ripley, loc. cit., p. 389.

⁷ M. Barlow ap. Ripley, loc. cit., p. 428.

In the normal course a promoter finds a flourishing industrial concern worth, say, £10,000, and decides to float it as a company for as much more as he can get; he obtains from the proprietors a contract to sell for £10,000; he then forms a small syndicate which is registered as a company; and purports to sell to it the contract or option at an enhanced price, say, £50,000; the syndicate next sells to the person who is to appear before the public as the vendor of the business, again, of course, with an advance; probably by this time we have got to £100,000; and lastly, the nominal vendor purports to make what is called a provisional contract with another dummy called the trustee for the company, subject to adoption by the company; by this time we are in the region of high finance, and the price may be anything up to seven figures. The promoters thus keep piling up profits on each transaction, and the so-called contract with the syndicate, with the nominal vendor, and the provisional contract with the trustee for the company are obviously not real contracts, all these persons being the nominees of the promoters.⁸

⁸ Loc. cit., p. 417.

The English legal attitude towards transactions of this nature is thus described in the Report of Lord Davey’s Committee on the Companies Acts which was issued in 1895:

If all this were done openly and the persons who are asked to subscribe were made acquainted with the real situation, and were told that the so-called vendor is a man of straw, and that the so-called contracts are only machinery for securing payments out of the company’s money to the promoters and underwriters and their friends, there could be no legal objection. If people with knowledge of the facts like to embark on an undertaking for which they are paying, say, twice as much as the real and present owners of it are willing to sell it for, they may be wise or unwise, the speculation may turn out well or ill, but it is their own affair.⁹

⁹ Page xi.

Whatever be the legal attitude towards such transactions, the moralist must condemn unreservedly the selling of property to the public at a price several times above its value, and he cannot accept the plea that subscribers knew or might have known what they were doing. As a matter of fact the large majority of subscribers are incapable of forming a judgment on the merits of the case even if they had the documents before their eyes; and on account of distance, or for other reasons, they cannot take the trouble even to look at them. They rely on the good faith of the promoter and of the directors, and these take the opportunity to rob them. Even a sound concern which would pay a good dividend on a fair capitalization can only hold out a promise of loss and ruin to those who have subscribed to a capital many times the value of the property.

The normal method of watering the stock of a new company which was described above may vary almost indefinitely in its details, but the malice of the operation remains the same; the operators obtain possession of other people’s money without having any just title thereto; they are guilty of injustice and must make restitution of their ill-gotten wealth. The same must be said of the crude device of issuing additional stock and then only applying part of the proceeds, or perhaps none at all, to the purposes of the company, but dividing them among the operators. Little better from the moral point of view is all stockwatering which lowers the value of the stock of the present holders without their consent or compensating advantage or necessity.

If the principles of moral theology require us to be uncompromising in these and similar cases, they allow perhaps of greater indulgence in certain other cases where individual rights are not infringed, though the law of the country may be violated. In some States, as in Massachusetts, there are anti-stockwatering laws which bind at least public service corporations, and there is a legal limit to the amount payable in dividends, usually 8 per cent. We will select from Professor Ripley’s book a few examples of the devices adopted to evade such laws as these.

Probably, the commonest of these is by the payment to shareholders of so-called stock dividends. These consist either of an outright bonus of new shares of stock or bonds, or in a mitigated form as stock sold below par or at less than market quotations. Such ‘‘melon-cutting,’’ in the parlance of Wall street, may range as high as 100 per cent., as in the Adams Express Company dividend of 1898. The notable Boston and Albany distribution of State stock in 1882 is a familiar example. This crudest form of inflation of capital, whether up to or beyond the increasing value of the plant, is the easiest to control directly. . . . Another somewhat more subtle mode of accommodation of capitalization to enhance revenue potential, since it may not really augment the volume of securities outstanding, is to substitute stock issues for funded debt. The tendency in this direction seems to be very marked at the present time among the strongest of the American railroads, such as the New York Central, the Pennsylvania, the Central of New Jersey, New York, New Haven and Hartford, and others. In some of these, outside of Massachusetts, the primary motive would seem to be to take advantage of rights to issue securities at par, where market value is high. But in addition there would seem to be the advantage of great elasticity in future dividend possibilities, within the same limits of total capitalization. Thus a substitution of possibly 8 per cent. stock for present 4 per cent. bonds clearly permits of the absorption of greater earnings to be derived in future.

The advantages of stock issues over bonds in the way of elasticity downward is of course always to be added; as they permit of a cessation of dividend burdens during periods of depression. Probably for this reason the tendency of most reorganization schemes seems to have been in the direction of retirement of bonds in favor of stocks. ... The gradual accumulation of a surplus, either by good management or by exceptional opportunities followed by a petition for its capitalization into stocks or bonds, constitutes one of the most troublesome problems in any attempt at strict regulation. For, as will readily be observed, in so far as such a surplus—either in the form of cash, of securities of other companies, or of additions to the original plant—represents augmented investment, it would seem to offer a proper basis for addition to capitalization. It cannot be denied that in this case the property has enhanced in value. Unfortunately for the company, however, a surplus stands too often in the public eye as witness to abnormal and undeserved earnings in the past. In those commonwealths which once provided in their early railroad charters for escheat to the State of all earnings in excess of a certain amount, usually¹⁰ per cent; or those like Massachusetts which under the recent law of 1898 provide for a special tax upon dividends of street railways in excess of 8 per cent, such a surplus may denote an actual evasion of legal liabilities. 10

¹⁰ Loc. cit., p. 139 ff.

Expedients of this sort will be of practical importance only where the law of the country restricts capitalization or the amount payable in dividends on investments. We assume of course that such laws are just, and good citizens will endeavor to conform their conduct to the laws of their country. It may be that a larger percentage than is allowed by law to be paid in dividends would be the fruit of extortion and unjust dealing on the part of the corporation, and if this be so the shareholders will have no right to the excess which is the fruit of injustice. Such excess is due to those who were wronged and from whom it was extorted, and it must be restored to them. Moreover, if the limit in the amount of the dividends allowed by law was accepted by the corporation and formed part of the conditions of incorporation it must of course be adhered to like all other contracts lawfully entered into. If however the above expedients are not productive of injustice or hardship to the public or to individuals, whether belonging to the corporation or not, but are merely illegal, the question for the moralist will be — What is the obligatory force of the laws which prohibit them? This will chiefly depend upon the intention of the legislator, and as modern civil legislators as a rule have no intention of making their laws rules for the individual conscience we shall be safe in saying that they do not bind under pain of sin. In so far then as the expedients described above and others similar to them are merely against positive law they will be illegal, but not necessarily and always sinful.

The same decision will be given with respect to another operation described by. Professor Ripley :

Next in importance to the conversion of a surplus into stock as a means of increasing capitalization is the expedient of funding contingent liabilities or a floating debt. . . . The creation of such a floating debt may sometimes serve as a means to the enlargement of capitalization. This would seem to have been the case of late with public service corporations in Massachusetts, particularly the electric light and power companies. Denied the expedient of surplus conversion into stock, both by the public policy already discussed and by the great depreciation in the cost of equipment, recourse has most naturally been made to the opposite expedient. Almost ten years ago the Gas Commissioners called attention to the desire on the part of companies managed by men of a speculative turn of mind to cover all expenditure for construction by issues of interest-bearing scrip.¹¹

¹¹ Page 144.

Of course if contracts are broken or the rights of shareholders or others violated by such a transaction it will be sinful, but in itself it would appear not to be so necessarily, however much it may be against the law. Any operation which lowers the interest on any particular stock or which affects its value must have the consent of the stockholders, otherwise it will do them an injury and therefore be sinful. This remark applies to a couple of operations described by Professor Ripley. The first consists in gerrymandering the constituent companies, so that those strong ones oppressed with surplus earnings may have aggregated about them the roads which are less favorably situated. The claim is openly made that the Massachusetts Electric Companies, composed of forty odd suburban traction lines, is having its membership so distributed in three main groups, each to be separately operated, as to effect this end. Thus the Lynn and Boston road earning perhaps twice its legally allowed dividend of 8 per cent, is made to average up its earnings with a number of small roads which are scarcely meeting operating expenses. The result is a 6 per cent dividend upon their united capital, with a net yield to shareholders far in excess of that contemplated under the law of 1898. The other stockwatering device attendant upon consolidation consists merely in the substitution of a high-grade for a low-grade security. For example, a weak company whose stock is quoted at 50, is merged in a second operating corporation, with stock, bid, we will say, at 200. This latter company issues new stock worth $200, share for share, in exchange for the $50 stock, which is thereupon canceled.¹²

¹² Loc. cit., p. 145.

The same judgment applies to another operation also described by Prof. Ripley:

The final method of evasion of anti-stockwatering statutes is found in the creation of independent finance corporations to which the operating company may be leased, sold, or trusteed. Thus in 1893 the Brooklyn City Railroad Company, operating with horse-power, was capitalized at $6,000,000. At that time its power was transformed to electricity ; and, as has been customary in such cases, the opportunity was seized for an increase of stock and bonds to $18,000,000. Simultaneously, the road was leased to the Brooklyn Heights Railroad Company, a tiny corporation operating only a mile of track and capitalized at $200,000. This company agreed to meet interest charges upon $6,000,000 of bonds and to pay 10 per cent upon the $12,000,000 of stocks of the leased company. Finally, in the same year, the Long Island Traction Company, incorporated under the laws of West Virginia with $30,000,000 capital, purchased the stock of the intermediary,—the Brooklyn Heights Company,—in order to absorb such surplus revenue as might remain over and above its obligations to the primary and sole operating concern. Thus was a fivefold increase of capitalization up to the desired figure finally effected."*

From what has been said it is obvious that stockwatering is a term which is applied to many different operations of widely different moral quality. What has been said will perhaps make it easier for the student of moral theology to decide on the moral quality of any particular operation that he may meet with.

13 Loc. cit., p. 146.